Chapter 4: Interest Rate Derivatives

4.2 Caps and Floors

Interest Rate Models
Damir Filipovic

4.2 Caps and Floors

Caps protect against high rates

Floors protect against low rates
Cap-Floor parity
Pricing under forward measures
Blacks price formula
Bacheliers price formula
Cap/Floor quotes in terms of implied
volatilities

Interest Rate Models

Caplets

A caplet with reset date T0 and

settlement date T1 = T0 + pays the
holder the difference between simple
spot rate L(T0 , T1 ) and strike rate .
The cash flow at T1 is
(L(T0 , T1 ) )+ .

T0

T1

Protects against rising interest rates.

Interest Rate Models

Price of Caplet
The time-T0 value of the caplet is
P(T0 , T1 )(L(T0 , T1 ) )+
= (1 + )

1
1+

+
P(T0 , T1 )

(1 + ) put option on T1 -bond with

1
expiry date T0 and strike price 1+
.

T0

T1

Time-t price of the caplet therefore is

Cpl(t, T0 , T1 ) = (1 + ) pput .
Interest Rate Models

Caps

A cap is a strip of caplets, specified by

reset/settlement dates T0 < < Tn
(T0 =first reset date, Tn =maturity)
a cap rate
for simplicity assume: Ti Ti1
The cap price at t T0 is
P
Cp(t) = ni=1 Cpl(t, Ti1 , Ti )

T0

T1

Tn1 Tn

with price of ith caplet Cpl(t, Ti1 , Ti ).

Interest Rate Models

Floors
A floor
is the converse to a cap,
protects against low interest rates,
is a strip of floorlets with Ti -cash flows
( L(Ti1 , Ti ))+ .

T0

T1

Tn1 Tn

The floor price at t T0 is

P
Fl(t) = ni=1 Fll(t, Ti1 , Ti )
with price of ith floorlet Fll(t, Ti1 , Ti ).
Interest Rate Models

Caps, Floors and Swaps

The following parity relation holds:
Cp(t) Fl(t) = Vp (t)
where Vp (t) is the time-t value of a payer swap with fixed rate , notional one,
and the same tenor structure T0 < < Tn as the cap and floor.
The cap (floor) is said to be
at-the-money (ATM) if = Rswap (t) =

P(t,T
P 0 )P(t,Tn )
ni=1 P(t,Ti )

in-the-money (ITM) if < Rswap (t) (floor: > Rswap (t))

out-of-the-money (OTM) if > Rswap (t) (floor: < Rswap (t))
Interest Rate Models

Black's Formula: Underlying Assumptions

Blacks formula assumes that L(Ti1 , Ti ) = F (Ti1 , Ti1 , Ti ) is log-normal with
dF (t, Ti1 , Ti ) = F (t, Ti1 , Ti ) dW Ti (t)
with constant > 0 and Brownian motion W Ti (t) under the Ti -forward measure.
Time-t prices of ith caplet and floorlet are
Ti



(L(Ti1 , Ti ) )+

Ti



( L(Ti1 , Ti ))+

Cpl(t, Ti1 , Ti ) = P(t, Ti )EQ

t
Fll(t, Ti1 , Ti ) = P(t, Ti )EQ
t

Interest Rate Models

Black's Formula for Caplets and Floorlets

Blacks formula for the ith caplet and floorlet price is
Cpl(t, Ti1 , Ti ) = P(t, Ti ) (F (t, Ti1 , Ti )(d1 ) (d2 ))
Fll(t, Ti1 , Ti ) = P(t, Ti ) ((d2 ) F (t, Ti1 , Ti )(d1 ))
where is the standard normal cumulative distribution function and
i
h
F (t;Ti1 ,Ti )
12 2 (Ti1 t)
log

p
.
d1,2 =
Ti1 t
: Black (or relative) volatility (same for all caplets/floorlets of a cap/floor).
Interest Rate Models

Bachelier's Formula: Underlying Assumptions

Bacheliers formula assumes that L(Ti1 , Ti ) = F (Ti1 , Ti1 , Ti ) is normal with
dF (t, Ti1 , Ti ) = dW Ti (t)
with constant > 0 and Brownian motion W Ti (t) under the Ti -forward measure.
Time-t prices of ith caplet and floorlet are
Ti



(L(Ti1 , Ti ) )+

Ti



( L(Ti1 , Ti ))+

Cpl(t, Ti1 , Ti ) = P(t, Ti )EQ

t

Fll(t, Ti1 , Ti ) = P(t, Ti )EQ

t

Interest Rate Models

Bachelier's Formula for Caplets and Floorlets

Bacheliers formula for the ith caplet and floorlet price is
p
Cpl(t, Ti1 , Ti ) = P(t, Ti ) Ti1 t (D(D) + (D))
Fll(t, Ti1 , Ti ) = P(t, Ti )

p
Ti1 t (D(D) + (D))

where is the standard normal cumulative distribution function, = 0 , and

D=

F (t, Ti1 , Ti )
p
.
Ti1 t

: normal (basis point, absolute) volatility (same for all caplets/floorlets of a

cap/floor).
Interest Rate Models

Cap and Floor Quotes

Cap/floor prices are quoted in terms of their Black or normal implied volatilities.
Typically: t = 0, T0 = = Ti Ti1 with
= three months (US market)
= half a year (euro market)

Interest Rate Models

Example of Cap Quotes

EUR ATM Cap Quotes, 30 August 2013:
BlackATMVol(%)
93.81%
90.31%
65.94%
58.65%
53.14%
49.12%
45.59%
42.17%
39.59%
37.04%
30.86%
28.70%
27.39%

NormalATMVol(bps)
33.23
46.94
60.15
70.25
77.76
83.54
85.60
86.46
86.94
86.52
84.08
79.81
73.01

100

80

80

60

60

40

40

20

20

10

15

20

25

Normal ATM Vol (bps)

CapATMPrice(%)
0.08%
0.35%
0.84%
1.61%
2.54%
3.60%
4.60%
5.62%
6.65%
7.67%
12.38%
16.15%
22.35%

Black ATM Vol (%)

100

Maturity(yrs)
1
2
3
4
5
6
7
8
9
10
15
20
30

30

Maturity (yrs)

It is a challenge for any interest rate model to match the given volatility curve.
Interest Rate Models